Automotive Warranty:

The Big Three feel the bite of increased warranty costs in the first quarter just as sales begin to fall. But how can companies be compared over time if their accounting standards and even their currencies are different?

Despite all the reports of massive recalls last year, the passenger car industry seemed to be doing just fine. Warranty claims for U.S.-based automotive manufacturers rose around 7% to $12.7 billion, but rising sales helped keep the claims rate more or less unchanged.

Then the Big Three turned in their first quarter 2005 financial reports, and Wall Street reacted badly. General Motors reported a 7% decline in automotive revenue for the quarter plus a $1.8 billion net loss in its automotive sector. Ford did a little better, showing a 1.4% rise in its automotive revenue, but a worrisome 67% decline in the profitability of that line of business.

DaimlerChrysler AG is officially based in Germany, so it reports in euro. That complicates comparisons with GM and Ford, which report in dollars, so we'll restrict our comparisons to percentages only. DaimlerChrysler's first quarter revenue was down 2% worldwide and was down 8% in just the U.S. market. Even revenue in Germany was down by 18%. Worldwide net income declined 30%.

Junk Bond Downgrades

This week, Fitch Ratings downgraded $292 billion in General Motors and GMAC long-term debt to BB+, becoming the second ratings agency after Standard & Poor's to lower the industrial giant's rating to a "junk" level. As of press time, only Moody's Investor Service had yet to downgrade GM. Once it does, GM will become the largest American company to ever see its debt cut to junk status.

Warranty was not a factor in these ratings downgrades. However, for at least two of the Big Three, things are moving in the wrong direction in respect to warranty. Both General Motors and DaimlerChrysler just reported their second-largest quarterly claims totals ever. GM reported $1.209 billion in first-quarter claims, topped only by its fourth quarter report of 2004's $1.23 billion.

DCX reported a first-quarter claims total of 1.466 billion euros, topped only by the second quarter of 2004's 1.479 billion euro report. Even if one makes assumptions about the recent volatility of the euro-dollar exchange rate, either of these quarterly totals would qualify DaimlerChrysler as the world's largest-ever warranty provider, paying claims at a rate close to $1 million per hour ($870,000/hr. at today's exchange rate). Put another way, assuming the average cost for warranty work is $500 per claim, DaimlerChrysler paid for one claim every two seconds.

Strangely enough, Ford reported exactly the same amount of claims in the first quarter as in the fourth quarter: $993 million. The company's warranty claims rate (as a percentage of sales) was also virtually unchanged at 2.5%, though it's up 0.3% from a year ago and up 0.1% from two years ago. Among large manufacturers since 2003, Ford's warranty numbers are about as dependable as they come, in the era of FASB Interpretation No. 45.

Warranty Sticker Shock

The big shock comes when you take out the calculator for GM and DCX. Because warranty costs for both companies are up and revenue is down, and because claims rates are computed by dividing claims by revenue, both these companies recently saw a massive spike in their claims rates. GM rose from a historical average around 2.8% of auto revenue spent on claims, up to 3.2% for the first quarter. DCX soared out of its usual band of 3.5% to 4.0% all the way up to 5.2%.

Exactly a year ago, DaimlerChrysler's claims rate was just over 2.7%. Two years ago, it was just over 4%. Over the same period, the company's accrual rate has risen as high as 4.95% and fallen as low as 3.75%. Interestingly, while claims are now at their highest level since 2003, accruals are at their lowest level. But thanks to some currency rate fluctuations and some well-timed changes of estimate, the company has seen its warranty reserve grow to 11.2 billion euros (US$14.6 billion) as of March 31. That also is a world record, as far as we know. GM has only US$9 billion in its warranty reserve.

It makes no sense to plot the warranty experience of these three companies in terms of dollars, euros, or percent, because doing so would result in figures that are not directly comparable. Not only would the 2003 and 2004 results be skewed by changes in the dollar-euro exchange rate, but also changes in the product mix. For instance, European carmakers might despair at the prospect of importing high-priced models into the U.S. and receiving dollars for their efforts. American carmakers might find it advantageous to manufacture in Detroit and export to Europe. Where it's made and where it's ultimately sold could change the warranty costs considerably.

Furthermore, until the 2006 model year rolls out this summer, the Chrysler Group is covering its passenger cars with seven-year powertrain warranties. That program, adopted in late 2001 and extended in 2002, was touted in all the company's broadcast and print advertisements as proof that Chrysler, Dodge, and Jeep vehicles were of high quality. They even created their own little warranty coat of arms for the program.

While we can't say how much more those longer warranties cost the company compared to GM's and Ford's less generous product coverage, it certainly helps explain in part why DCX consistently sees higher warranty costs per vehicle, per quarter, or per unit of revenue. But it's about to disappear as a point of differentiation. Last week, the company said the longer-than-average powertrain warranties are no longer a major selling point, so it's reverting back to three years/36,000 miles coverage for both bumper-to-bumper and powertrain. One would think there would be a reporter or a stock analyst somewhere in the world who might see fit to mention the company's spiking and record-setting warranty expenditures, but all apparently suffer from the same lack of interest in warranty as Chrysler's customers.

Different Product Mixes

Besides duration, there also is a very real difference in product mix. Even before merging with Chrysler, Daimler Benz was a major player in the heavy truck and diesel engine businesses. GM is deep into satellite services, and also makes locomotives. Ford is a major player in car rentals. Though they all make the bulk of their revenue from the sale of passenger cars, their product lines are different enough to complicate warranty comparisons.

Still, without knowing all the details of each automaker's internal accounting standards, it's impossible to say whether one's 2.5% is better or worse than another's 4%. It could be the claims rates are different because of what they include and exclude. One company could count freight costs on returned parts as a warranty expense while another may not. One company could combine product recalls and warranty work into a single account while another might keep them separate.

Constant Accounting Methodology?

Given all these complications, it's still possible to compare one company against itself. Though there are probably still some book-cookers in the world, we have to believe that the vast majority of companies are not manipulating their warranty costs by periodically including and excluding certain expenses. If they choose to include or exclude freight costs and call center costs in their warranty calculations, we have to believe they do it all the time -- not just when they need to make their numbers.

Therefore, we now have three sets of three: warranty claims rates for three auto manufacturers during three first quarters. All three are at their highest points during the first quarter of 2005, but as the data shows, Ford has changed the least.

This is where the data gets a bit experimental. Let's assume that every company and every product line has a "normal" warranty claims rate. For some companies and some products, 1% is normal. For others, 4% or perhaps even 8% might be normal, such as seems to be the case with inexpensive PC printers, where most of the money is made from sales of ink. Some companies might be highly seasonal, for instance motorcycles and golf carts, which would hardly see use, let alone warranty claims, during the cold months of the year. But let's say that for every company and every product line, there is a normal rate of warranty claims.

This being only the ninth quarter in which many manufacturers have had to comply with FASB Interpretation Number 45 by disclosing their warranty expenses, there's hardly enough data to allow for the computation of any long-term averages. For as the car companies are now revealing in painful detail, warranty costs may rise during downswings in the economy to rates that are above and beyond their normal range. What we really need is nine decades of warranty data, which the automakers no doubt have at their disposal but which we never will.

The Starting Point

Until something better comes along, let's just pick the first quarter of 2003 as the beginning of warranty data. Let's assume that for DaimlerChrysler, 4.1% is the "normal" warranty claims rate. For GM let's choose 2.8% and for Ford let's choose 2.4%. Actually, those 1Q 2003 numbers are quite close to their nine-quarter averages, so they might not turn out to be so arbitrary. But there's always the possibility that during that particular quarter, things weren't so "normal" for some companies.

Since we can't compare percentages, let's instead compare the ups and downs. Whatever their claims rate in percentages, let's set every company's claims rate to equal 1.0 during the first quarter of 2003. If the claims rate suddenly doubled from 3% to 6%, it would change from 1.0 to 2.0 on this scale. If it fell from an initial 4% to 2%, under this scale it would change from 1.0 to 0.5. The actual percentages don't matter; it's the changes in percentage that matter.

This means that companies can be compared by the magnitude of their deviance from the initial point. Unless a company is changing the accounting formula it uses to compute warranty costs over time, this methodology would measure just the changes in the ratio between claims and revenue. It wouldn't matter if one company included certain costs and another didn't. The inclusive company would start out at 1.0 even if their percentage was a bit higher. One could say it was normal for them to include certain costs, while for other companies and other industries it would be normal not to do so.

Two weeks ago, your editor presented some of this automotive data to the attendees of an Early Warning Standards conference hosted by the Automotive Industry Action Group. Organizers said the event drew 337 people, which was more than even the Warranty Chain Management show in March managed to muster. And this was the third or fourth time a warranty-related event has proved to be a bigger draw than was initially expected. Roughly three-quarters of the attendees were able to drive in to the conference's suburban Detroit location from their office, which is perhaps appropriate for an automotive event and which undoubtedly also helped boost attendance. But still, leaving the office for an all-day conference is not as routine as perhaps it was in the 1990s.

The complete slide show your editor presented is online at the AIAG Web site. But there's new data to present, so let's update at least one slide. The comparison of GM, Ford, and DaimlerChrysler, where all three are set to start at 1.0 at the outset of 2003, clearly shows that what's going on during the first quarter of 2005 is far from normal.

Detroit's Big Three
Warranty Claims Rates
First Quarter 2003 = 1.0

As the graph illustrates, GM is now nearly 18% above what had been considered to be its "normal" warranty claims rate. It's entirely possible that over the long term, 2003 and 2004 were below normal and what we're seeing now is a return to historic norms. Only time will tell. It's interesting, though, that as both GM and DCX see a recent spike, Ford barely moves at all. It's as if Ford is oscillating around its long-term average -- up a bit, down a bit%, but always within a tight band of 0.9 to 1.1. Again, time will tell if this pattern can hold.

DaimlerChrysler, however, has seen its warranty claims rate dive in early 2004 and spike in early 2005. In fact, the swing from one quarter to the next has been as large as 693 million euros (US$900 million), which, one would think, would be large enough to attract the attention of the folks who analyze these companies for a living.

What's more disconcerting is the volatility in both directions. Assuming that the first quarter of 2003 is "normal" (an admittedly tenuous theory), this company has seen claims rates fall 33% and rise by 28% -- all within a single year. And as the data for Ford (and until last quarter GM) illustrates, volatility of this magnitude is unusual for a large company, especially for one at the end of the supply chain.

It turns out that the 30% mark is a kind of early warning signal all by itself. Of the top 20 U.S.-based automotive warranty providers, including both OEMs and suppliers, only three saw their claims rate rise by 30% or more at any point within the past two years, and only three saw it fall by 30% or more. Setting all 20 so that their claims rate equals 1.0 at the outset of 2003, it's easy to see which have distinguished themselves through their volatility.

The three largest increases are colored red, and the three largest decreases are colored green. The remainder -- those that stayed within a band of 0.7 to 1.3 -- are colored black. As the chart shows, the largest change of all was turned in by Johnson Controls during the third quarter of 2003. It's easy to see why. The company began the year with claims of $8.8 million, equal to only 0.15% of sales. By the third quarter, that amount had grown to $24.8 million. Thanks to sales increases, the claims rate rose only to 0.27%. However, that's a change of more than 80%, equal to a change from 1.0 to 1.8 on this scale.

The problem is that the first and third quarters of 2003 were something of anomalies for Johnson Controls. Warranty claims were artificially depressed during the first quarter by the timing of a reimbursement from a supplier, and were artificially boosted during the third quarter by the timing of a chargeback from an OEM customer. Since FASB Interpretation Number 45 requires manufacturers to report only net figures for claims, these extraordinary gains and charges never make it into the financial statements. Also, Johnson Controls' quarterly claims are averaging closer to $12 million and 0.2% of sales. So perhaps its appearance on this chart is nothing more than just a case of bad timing.

Delphi hasn't been able to file its financial statements for the past three quarters, so the line representing its claims experience stops suddenly during the second quarter of 2004. Claims have not really changed by much -- going from 0.3% of sales in 2003 to 0.4% of sales just before the accounting problems set in. However, that's a one-third increase in the claims rate, which is among the largest within this select group.

Sustained Warranty Decreases

On the down side, which of course is the good side of this graph, we see Deere & Co., Thor Industries, and Cummins Inc. turning in gradual but sustained decreases in their warranty claims rates. Deere began 2003 showing a claims rate of 3% based on claims of $68 million and sales of $2.27 billion. In the first quarter of 2004, the claims rate was 2.8%, based on $81 million in claims and $2.9 billion in sales. By the first quarter of 2005 (not pictured in this graph), the claims rate fell further, to 2.6%, while claims continued rising, to $93 million.

The main reason for the sustained decline, of course, is continued rising sales. Deere has seen at least three quarters where it paid out more than $100 million in claims, but its claims rate never went above 3%, thanks to rising sales volumes. Company executives said the other key is gradual but sustained quality improvements, which over the past two years have allowed the company to reduce its accrual rate from 3% down to around 2.5%. That in turn means lower expenses and of course higher net income.

It's much the same story at Thor Industries. The recreational vehicle maker has seen its claims rise from under $10 million per quarter to nearly $12.5 million in one instance, but rising sales have allowed it to keep its claims rate down. In a seasonal business such as RVs, it's perhaps misleading to pick a winter quarter as the starting point set to equal 1.0, but even in other seasons the claims rates that used to be over 2% are now below 1%. There doesn't seem to be any seasonality to this particular downward trend.

As more and more companies are added to the mix, the trend becomes less clear. For instance, there was one smaller automotive company that went from 1.0 to 7.0, then down to 0.7 -- all within a single calendar year. The company's quarterly claims have ranged from $250,000 to $4.5 million, and its claims rates have varied from 0.2% to 2.2%. Suffice it to say that warranty expenses are out of control at this particular company. There's nothing normal about this kind of volatility. Even with a decade's worth of data, it's unlikely there would be any pattern to the peaks and valleys.